A Bit about Bitcoin

The spectacular rises in the prices of Bitcoin and other “cryptocurrencies” are attracting attention reminiscent (to some) of the pet rock craze of the 1970s or (to others) the tulip mania craze of the 1630s.

What is the frenzy all about? What are the implications for investors?

Here are some thoughts about this subject.

What is Bitcoin?

Bitcoin combines encryption and distributed computing to create a digital chain (known as blockchain) of verifiable transactions. The underlying blockchain technology has immense potential. It represents—as one analyst put it–“a better way than we’ve ever had to document and enforce ownership claims”.1

Investors will have lots to ponder as blockchain technology spreads to applications beyond cryptocurrencies. Many industries could be profoundly altered (and disrupted) by the blockchain technology. A partial list of areas that may be impacted include:

Title searches on property

Many banking and payment functions

Global supply chain management

Medical information

Perhaps even financial market exchanges themselves

But it is important to recognize that while blockchain makes it possible, Bitcoin does not convey ownership rights in the underlying blockchain technology. Bitcoin is not a way to get in on the ground floor of blockchain’s potential.

What about Bitcoin’s potential as a global currency? In a world of 7.6 billion people, isn’t it going to continue to skyrocket in price as it becomes a ubiquitous world currency?

Before we attempt to answer this question, we note that as investors we appreciate the appeal of Bitcoin as a rival currency to those issued by governments. Ever since governments began to issue currencies, abuses of their money monopoly power have been frequent. Devaluation of currencies (via inflation and other means) has been all too common over time, much to the detriment of investors.

Bitcoin could conceivably fix this problem with government issued currency by restricting the amount of Bitcoin that can exist. However, there also appears to be a serious practical issue of whether Bitcoin could “scale” in size to ever represent a viable alternative to government issued currencies.

Scalability is not the only impediment to Bitcoin becoming a world currency.

Energy demand to power Bitcoin

Some estimate the electrical power required to expand Bitcoin from its current size exceeds that required to power the entire country of Denmark…for a year.

A recent World Economic Forum article states:
“In 2020 Bitcoin will consume more power than the world does today”.2

Government competition

Governments are likely to be very reluctant to cede currency power to Bitcoin or other competing cryptocurrencies. Our Federal Reserve is reportedly exploring the possibility of issuing “Fedcoin”—a government sponsored digital currency.

Some countries have made Bitcoin illegal. Other countries have restricted its use. Could that happen in the U.S.? There exists precedent, so it could. In the 1930s President Franklin Roosevelt issued an executive order making it illegal for U.S. citizens to own gold. Gold as a medium of exchange became only possible between global central banks.

The value of Bitcoin as a viable currency would clearly be threatened if governments issue a competing currency or take actions to restrict Bitcoin’s acceptance.

Extreme price volatility

Extreme price volatility in Bitcoin inhibits its ability to becoming a functional currency.

Imagine for a moment that someone took out a home mortgage at the start of 2017 denominated in Bitcoins. Owing 500 Bitcoins would have represented a debt of approximately $500,000 on the first day of 2017. Today their 500 Bitcoin debt would represent about $9,000,000!

In addition, if the price of Bitcoin can rise or fall 10% or 20% in a day—a price swing which exceeds the profit margins of the vast majority of businesses in the world–who will be willing to use this as a medium of exchange in commerce?

What about Bitcoin as an investment?

Bitcoin has no intrinsic value. It doesn’t pay dividends or interest. Nor does it generate a cash flow stream that owners have a claim against.

Therefore, Bitcoin’s valuation rests on supply and demand. And given the relatively fixed supply of Bitcoin as part of its fundamental appeal—Bitcoin’s value rests on its demand alone. Increasing demand for Bitcoin suggests its price will rise. Declining demand suggests a lower price.

Given the practical problems with Bitcoin becoming a viable currency, enduring demand for it is highly uncertain and renders it an extremely speculative financial bet.

People borrowing on their credit cards to buy Bitcoin (to the tune of an estimated $5 to $10 billion) and the mania for all things related—see Bloomberg headline below, brings to mind the following Isaac Newton quote uttered when he lost a fortune speculating during the South Seas frenzy:

“I can calculate the movement of heavenly bodies but not the madness of men”.

Long Island Iced Tea stock soars after changing its name to Long Blockchain

Bloomberg December 21, 2017

Rather than speculating on the price of Bitcoin, or a company name change, we believe investors will be better served assessing the investment implications of the actual blockchain technology itself. On this subject, we will have much more to share in the months ahead.